Schroders Management Economics and Financial Markets January 2018

Active risk management – avoid acting on emotions

According to economists and market strategists, signs are looking good for the coming year. All indicators are pointing towards a continuation of the economic recovery along with modest . After a very strong performance in 2017, everyone wants even greater returns this year (is this a sign of greed?) and willing to take even more risks. For this reason, we have seized this opportunity and realised some gains. However, we are maintaining a constructive stance with regard to real investments and continue to avoid long-term government bonds.

After a decade of extremely expansive following pages outline the various scenarios and their which culminated in a ten-year upturn in the stock mar- impact on the asset classes. kets, the central banks are now attempting to move Those of us who experienced the end of the dot-com away from this and set in motion a return to a normal bubble in 2001 will be able to draw a number of parallels monetary policy without causing any major damage. here and are thus not placing full trust in the economists This exit represents the end of the risk-free world, i.e. of and market strategists. The furore surrounding bitcoin moderate growth without any inflation. that is gripping everyone thanks to new media does not Could this mean that the central banks are also herald- seem to be coming to an end in spite of the warnings ing the end of the stock market rally and of countless issued by various renowned investment experts and excesses at the same time? central banks. A wide range of banks and stock markets have developed new instruments for their clients. There Our macroeconomists and strategists have taken a look is the potential for massive disappointment here. I be- at this question and came to the conclusion that the lieve that the above arguments speak in favour of hold- global economy is extremely robust. The simultaneous ing a short-term, tactically defensive position. upswing in various economies results in a rise in growth expectations and a slight increase in inflation. A number How are we positioned at the moment? of scenarios have been developed as an investment In principle, we have aligned the portfolios with our compass in order to review the impact on the asset clas- main scenario and are maintaining a preference for ses. equities and other real assets. We are avoiding long- The main scenario (reflation) envisages strong growth term government bonds and favouring inflation-linked along with the rising inflation that is associated with it. bonds. From a tactical perspective, we have taken the This scenario could be driven by a global trading boom opportunity to realise gains on our equities and corpo- or the introduction of fiscal measures, and would be rate bonds and invested the proceeds into inflation- positive for real assets, such as equities, real estate, linked bonds in order to slightly reduce the portfolio risk. infrastructure and commodities, provided that inflation This should allow us to benefit from a short-term correc- does not rise too quickly or too sharply. Nominal assets tion. such as government bonds or corporate bonds would be Giovanni Leonardo, CFA the biggest losers in this scenario, as inflation would Head Investment Management transform them into real burning machines.

The rather improbable but very real scenario of and stagnation would in contrast lead to an extremely unpleasant phenomenon. Rising inflation combined with declining growth would have a negative impact on all asset classes, resulting in all of them being revalued. The

Schroders Wealth Management Economics and Financial Markets January 2018 1

Review and outlook

The year 2017 started with a number of worries and ended on a much more optimistic note. Regardless of the many causes of concern, ranging from elections, unsteady politi- cians, questionable policy all the way to nuclear sabre-rattling and a refu- gee crisis – the real economy always showed resilience. We have witnessed a globally synchronised recovery, lower unemployment rates, low inflation, low rates and booming stock markets. Those investors willing to take some risk were richly rewarded as we look back on an excellent year in the financial markets, despite the summer months being difficult. US dollar-based investors enjoyed solid foreign currency gains, while those measuring returns in saw their performance reduced by the strong cur- rency. Swiss investors, for the first time in years, did not have to worry about a strong Swiss franc. Commodities and gold were stronger as well. 2017 was also the year of cryptocurrencies entering mainstream financial markets and enjoying spectacular, alt- hough unsustainable, appreciation. 2018 is not free from obstacles and may not neces- sarily end as well as last year. September laid the foundations for a financial market increased the likelihood of moving the eurozone to rally that lasted throughout the fourth quarter. Stocks some sort of “debt solidarity”. climbed in global equity markets, notably in the US, Ja- Growth delivered a positive surprise on a global basis, pan and emerging markets (Europe was basically flat) notably in Europe and Japan where significant improve- and interest rates were stable or even declined in some ments were recorded in growth rates and sentiment, markets. The quarter was marked by the US tax reform while the US and broadly met expectations. Low passing congress in late December as well as difficult rates and rather low commodity prices, free capacity and election results in Germany where no new government a business-friendly US administration bode well for this has been formed so far. Additionally, all eyes were on development. Inflation rates and wage growth stayed central banks. The (Fed) seems to follow low, despite unemployment reaching low levels in cer- a clearly communicated path of tightening, while the tain regions. (ECB) is taking a more cautious approach, delaying any exit from Quantitative Easing Improved supply discipline within OPEC, increased de- (QE) until next year. Measured in local currencies, world mand from improved economic activity and certain sup- equity markets advanced by 16.3% in 2017, gaining ply constraints in the US lifted oil prices significantly. 20.1% in US dollars and 9.6% in British pounds. Industrial metals enjoyed considerable price gains as well, while gold, although higher, somewhat disappoint- Following a brief period of consolidation, the euro ad- ed. Despite a surge in natural disasters, agricultural vanced 1.9% against the US dollar during the fourth prices stayed low. quarter, while overall currency movements were less pronounced in the same period. Over the whole year, There is no obvious reason to not be optimistic for the the euro was the biggest winner, gaining 14.0% against world economy at this stage. Cheap money, existing free the US currency which in turn dropped 4.3% against the capacity in world trade and low inflation are an ideal Swiss franc. Therefore, US-based investors saw signifi- background for a continuation of overall moderate cant currency gains on their foreign, unhedged holdings. growth. Existing risks are being pushed to the back- GBP-based investors were less fortunate, as the British burner. pound was strong against most major currencies with The following tables summarise the performance of the the exception of the euro. major equity and bond markets during the fourth quar- Low inflation rates and dovish central banks did not ter and year to date, expressed in local and reference move interest rates much higher from their very low currencies. base. Rates for 10-year treasuries stayed – despite fluc- tuating somewhat – almost unchanged throughout the last quarter and the whole year, while the Fed raised rates three times last year. Rates moved higher, howev- er, for 2-year treasuries (0.7%-points during the year). European bond market returns were more divergent. German rates rose as spreads to peripheral European countries narrowed, with some countries enjoying a significant reduction in yields during the year. Here, there were two factors in play– improved economic con- ditions within the eurozone and political events that

Schroders Wealth Management Economics and Financial Markets January 2018 2

Equity markets (in %) Bond markets (in %) 4th quarter Europe Emerging 2017 USA UK Japan World USD GBP EUR CHF ex UK Markets

In local currency 6.03 4.08 -0.22 8.42 5.34 4.94 0.26 1.87 0.52 0.48

In USD 6.03 5.09 1.63 8.46 7.09 5.14 0.26 2.85 2.38 0.04

In EUR 4.09 3.18 -0.22 6.49 5.13 3.22 -1.58 0.99 0.52 -1.79

In GBP 5.02 4.08 0.65 7.44 6.07 4.14 -0.69 1.87 1.40 -0.92

Based on the MSCI price index, Bloomberg Based on Citigroup Bond Index, Swiss Exchange, Bloomberg

Equity markets (in %) Bond markets (in %)

YTD 2017 Europe Emerging USA UK Japan World USD GBP EUR CHF ex UK Markets

In local currency 19.51 7.25 11.12 17.60 27.34 16.26 3.24 3.76 0.53 0.14

In USD 19.51 17.51 26.65 21.89 34.35 20.10 3.24 13.68 14.59 4.71

In EUR 4.70 3.06 11.12 6.84 17.71 5.23 -9.56 -0.28 0.48 -8.27

In GBP 9.01 7.25 15.60 11.24 22.57 9.57 -5.82 3.76 4.59 -4.49

Based on the MSCI price index, Bloomberg Based on Citigroup Bond Index, Swiss Exchange, Bloomberg

Economy: stable above 3% the risk of inefficient capital allocation and the covering up of structural issues. It took ten years from the start of the financial crisis for the world economy to fire on all cylinders once again. Although we share the generally positive economic and This was finally the case in 2017. Except for a few isolat- market outlook of most forecasters, we will take a look ed cases, all industrial and emerging countries show at various scenarios that may negatively affect financial positive growth rates, presumably lifting global growth markets and the economy. above 3% last year. This figure remains well below the In our view, the biggest risk lies in an overheating of the rates seen during mid-2000; Nevertheless, growth is global economy. The US and German economies are now more evenly distributed between the regions. those most exposed to this risk. In the US, unemploy- In Japan, the return to sustained growth rates (seven ment has fallen to a very low rate, and the tax reform consecutive quarters of positive growth) is especially and infrastructure spending (as planned) may further welcome as much as it is in Europe, where all eurozone fuel an economy that is already growing above its trend, members are now enjoying growth. Japan seems to which may trigger inflation. Germany is in a similar posi- profit from aggressive central banking policy and fiscal tion within Europe. So far, there has been no significant expansion. As reforms are slow, there is always the rise in inflation rates – neither in the core rate that ex- question of sustainability. Europe suffers from the same cludes volatile food and energy prices, nor in the overall problem: in some European countries, the recovery is rate. Wage growth has not accelerated despite low un- more a function of Germany’s leadership and ECB action employment. Why this is the case is not clear. We will and less the result of deep reforms in labour markets or most probably see a combination of various factors, gains in efficiency. Nevertheless, the current period ranging from the ability to shift labour to low-cost coun- gives Japan and Europe a chance to address long-lasting tries, digitisation or – particularly in the US – a return of issues that are much more difficult to change during certain idle workers to the labour market, increasing the periods of stagnation. participation rate.

A rather positive element of the current upturn is that There is a relatively high risk that such dampening fac- growth is synchronised but remains on a moderate level. tors, combined with artificially low rates and rising This prevents the overheating of commodity markets, commodity prices, are losing influence and wages and stops wages from rising too fast and thus keeps inflation prices will start to climb. Higher inflation rates are not in check. There are a numbers of risks, however. In some necessarily bad for growth – it depends on the magni- countries, regional differences are getting bigger, laying tude of the rate increase and the central bank reaction. the foundation for social unrest and it should not be Should central banks see themselves forced to change overlooked that in Japan and Europe – and to a lesser monetary policy fast, growth and the financial market extent in the US– interest rates are artificially low, raising will suffer. Most probably, such a change of course will come in the form of more frequent rate hikes by the Fed

Schroders Wealth Management Economics and Financial Markets January 2018 3

and an early end to QE by the ECB. Even in Japan, an exit Although none of the above scenarios can be ruled out, from the ultra-loose monetary policy seems possible. we believe that 2018 may see a continuation of moder- This may lead to “stagflation”, where growth slows while ate growth without much inflation, as economic over- inflation remains high for some time. heating is not visible and central banks can be expected to move carefully. We therefore expect the world econ- The opposite, a return of deflationary developments, omy to grow by 3.3% this year, i.e. at roughly the same seems less likely. This may happen should central banks speed as in 2017 commit a “policy mistake” by tightening monetary policy too early and by too much in anticipation of inflation and Not much had been expected from Europe at the start in order to “normalise” rates. Inflation may fall while of 2017; however, the continent surprised everyone with growth slows, putting in place a “deflationary spiral”. a broad-based upturn. For the first time since the end of Looking back at central banks over the last decade, this the financial crisis, all of the countries within the euro- seems unlikely as central banks have used unconven- zone experienced positive growth rates and general tional policy measures in order to prevent deflation. economic optimism. This has been attributed to Germa- There is, however, some political pressure being exerted ny’s long-lasting, stable boom which has helped support on central banks to move back to “normal” interest rates all of Europe. Some countries, most notably Spain and and the chair of the Fed’s open market committee will France, have enacted promising labour market reforms. change this year, as Draghi’s term at the ECB ends in There are still, however, no solutions to the demograph- 2019. ic time bomb and the high level of government debt in many countries. China can be identified as a third risk to the markets and the world economy. China’s growth is above 6%, con- The ECB’s answer to this broad-based return of growth is tributing – together with – considerably to the somewhat puzzling in the sense that they have an- economic development of emerging markets and the nounced an only slightly reduced continuation of QE, in rest of the industrialised world. Any slowdown in China addition to keeping interest rates at zero. The ECB will be felt from Asia to Europe and the US. There can be seems to want to continue targeting low rates in order no doubt that China’s financial system is over-leveraged to help reduce borrowing costs for Italy, Spain and Por- and carries a lot of credit risk. tugal, thus preventing a rekindling of euro tensions.

The banking system and a large part of the industrial To this end, political developments recently helped the base is government-controlled, giving the state enor- ECB. France’s influence has grown following a landslide mous power to intervene in the economy and in mar- election last year, coupled with political uncertainty in kets. Additionally, the political landscape is difficult to Germany and a partial loss of power for Ms. Merkel. interpret from the outside. China’s government may Political forces pushing for more European “solidarity” come to the conclusion that financial excesses are to be are gaining ground. It is no coincidence that govern- purged while accepting short term negative effects on ment bond interest rates differentials have narrowed the real economy, exerting deflationary forces on the following the French election. Nevertheless, a system of world economy. At the beginning of 2016, there was a common European debt is not yet close. Italy’s election brief period when such a development seemed to take may inject some additional political uncertainty. place, instantly bringing panic to financial markets glob- As far as growth is concerned, the next few months will ally. There are no concrete signs, however, that China is not disappoint. The stronger euro will have a slightly about to enact drastic measures of this kind. negative impact, but low rates and a buoyant global While the above three scenarios have a more indirect economy will keep Europe afloat. We are looking for influence on financial markets, there is a fourth risk that 2.3% growth this year. lies within the markets themselves. The United Kingdom is going through somewhat more There can be no doubt that a prolonged period of difficult times. The all-important Brexit is not well sup- “cheap money” has produced exuberance in certain ported politically; concessions had to be made to Brus- segments of financial markets. The latest rally of stock sels in order to simply start negotiations about the fu- markets, the compression of credit spreads, the boom in ture relationship. Such compromises are too generous in real estate and the demand for Crypto-currencies is at the eyes of many Brexit-supporters, while others would least partially the result of unconventional monetary like to stop the whole process altogether. The negotia- policy. One cannot exclude that the overvaluation that tors do not receive much political support, while the exists in certain segments may deflate without notice, British corporate community is waiting impatiently for causing chain reactions in the markets. The global bank- the definitive results. ing system, although in better shape than a few years Under these circumstances, growth has been somewhat ago, may not be healthy enough to absorb such shocks. disappointing in the UK, remaining stable at 1.5%, alt- Unfortunately, the nature of “bubbles” means that they hough the weaker British pound has helped to absorb can only be detected when they burst, otherwise, they the shock of Brexit. Higher inflation, however, is an un- would not exist. welcome side effect of the weak pound, reaching 3% in September and prompting the (BoE) to

Schroders Wealth Management Economics and Financial Markets January 2018 4

raise rates for the first time in November last year. A the fiscal deficit and the BoJ will join the Fed and ECB at tight labour market, robust consumer sentiment and the some stage by providing a path out of the current spe- state of the global economy has supported this decision. cial situation.

It should not be ignored that Britain, for the time being, Additionally, not much has changed when it comes to remains a member of the EU and has not seen any real the difficult demographic figures in Japan. Some reforms disadvantages in its dealings with European partners. have made it easier for women to join the labour force; The biggest fear in Britain is the exit of important eco- however, this does not compensate for low birth rates nomic sectors and a reduction of investment activity. It and an almost complete lack of immigration. remains to be seen whether negotiations move along We estimate Japan’s growth at 1.7% in 2017 and 1.8% in fast enough to keep these risks at bay. 2018. We expect the UK to grow at a rate of 1.6% this year. The economic environment could not be any better for A lot has been written on the topic of Donald Trump emerging markets. Synchronised growth of the devel- derailing the US and the world economy; however, very oped world and a weaker US dollar puts most exporting few of the predictions have actually come to pass. On emerging markets in a sweet spot. Also, China has been the contrary, it seems that a business-friendly president able to keep official growth rates around 6.5%, thus has been sufficient to lift the sentiment of both consum- providing another boost to the region. ers and business. Some low-level deregulation took President Xi’s power was consolidated and enhanced place as government agencies and courts were staffed during the party congress in October, allowing him to with more conservative personnel. Consumer sentiment tackle longer-standing issues in the financial systems has also reached a record level. Having passed a wide- such as excess leverage and the shadow banking sys- reaching tax reform in December, an important election tem, just as he fought corruption during his first term. promise has been fulfilled which could possibly give the There are early signs of tighter credit conditions and US economy another boost towards the end of a well- borrowing rates have risen recently. It remains to be advanced cycle seen, however, how fast it will be possible to move China In the third quarter, growth reached 3.3%, unemploy- from an industry-driven economic model to one that is ment declined to 4.1% and the participation rate started more service orientated without compromising growth to improve slightly. We can assume that growth of that and thus preventing social unrest. The service sectors magnitude is already above sustainable, inflation-free currently enjoy higher growth rates than manufacturers. growth rates. This makes it even harder to explain why These changes, however, constitute a risk for emerging wage growth remains subdued, hovering around 2.5-3% markets and for the world economy; However, there is and not providing much real growth. As mentioned, this no hard landing in sight. is not an isolated US phenomenon and may well change This is good news for Asia, where the dependence on given the tightness of the US market. Furthermore, it demand from China remains high, and for commodity clearly poses a risk of rising inflation within the US. exporting countries, as industrial demand from China The Fed communicated its plan to abandon QE and ul- plays an important role for stable prices. tra-low rates well in advance and it has thus far worked We estimate that China grew by 6.8% in 2017 and according to schedule. The Fed rate has been raised five emerging markets as a group by 5.0%. China’s growth times since 2015 and three more hikes have been an- may slow slightly to 6.4% in 2018, while growth rates in nounced for this year. Work has started on reducing the emerging markets should be stable. Fed’s balance sheet. US monetary policy is by no means fully “normalised”, but progress has been made without Equities: reasons to be worried? creating any uncertainty in the markets to date. The president’s economy-friendly politics may play a role in The performance of equity markets – when measured in ensuring this continues. local currencies – varied widely between regions in 2017. The US, Hong Kong, Japan and emerging markets out- We believe that US will record growth of 2.5% in 2018. performed Europe, where Germany and Italy beat the Japan celebrated its seventh consecutive positive quar- UK and Spain. Most of the differences can be attributed ter. Premier Abe’s policy of ultra-low rates and expansive to fourth quarter performance, as the US and Japan fiscal spending has played out well so far for both the pulled ahead while Europe stagnated. When factoring in economy and for his political well-being. Abe was re- the strong euro, the performance of the US market was elected with a strong mandate. considerably lower.

The Bank of Japan (BoJ) can easily justify the continuation Differences between sectors were also quite pro- of its monetary policy by looking at low inflation rates nounced. In Europe, the US and Asia, information tech- and low wage growth. Nevertheless, at some point in nology was well ahead, followed by materials and cycli- time a normalisation of fiscal and monetary policies has cal consumer – the latter especially in the US. to be started. An increase of the consumption tax as Weaker sectors included health care in Europe, energy in early as this year may be unavoidable in order to control the US and telecommunications in both regions.

Schroders Wealth Management Economics and Financial Markets January 2018 5

In most markets, higher prices meant higher valuations spreads from their higher coupons, investment-grade as profit increases lagged behind stock market perfor- bonds are more at risk. mance. Standard measures show the US as expensive, Inflation-linked bonds may provide some protection while Japan and emerging markets look less dear. against rising inflation. As current expectations are low, Low interest rates, low inflation and a positive growth any negative inflation surprise will have a positive impact outlook continue to be a positive backdrop for stocks, on the asset class. The US market is favoured in this although a repeat of the 2017 performance cannot be sector. expected under realistic scenarios. Government bonds with longer maturities look rather High valuations and a long period of rising stock prices expensive; however, they may provide some protection leave markets vulnerable to shocks. In some of the sce- as a “safe haven” in the event of a stock market correc- narios outlined above, our positive outlook will be put to tion. the test. Faster-rising rates, deflation or a bursting bub- Finally, local currency emerging market bonds still offer ble would lead to lower equity markets. In any case, some potential. They delivered high returns last year. more volatility is to be expected, as – at least in the US – Relatively high coupons are coupled with a chance of cash starts to offer a viable alternative to stocks. lower rates. The currency risk, however, has risen, espe- We can expect, however, the central banks to keep a cially against the euro. close eye on the financial markets as they tighten mone- tary policy. Not every stock market correction will be met Currencies: back to the euro? with monetary easing. Nevertheless, central banks are Over the last few months, there seemed to have been a well aware that financial market turmoil may derail the certain equilibrium between the US dollar and the euro, economy, most probably providing some sort of support as an active Fed stood against a more cautious ECB and in the case of a full-blown crisis. a widened interest rate differential between the US and As we expect interest rates to rise slowly, more cyclical, the eurozone. As growth rates became more synchro- growth-oriented industry sectors are favoured. Defen- nised, Europe is no longer expected to grow faster than sives (telecommunication or utilities) may continue to the US. Recently, however, the euro started to regain disappoint in such a scenario. Well diversified portfolios some strength and his risen close to the high of Sep- should not completely avoid such sectors for their de- tember, having gained 1.9% during the fourth quarter. fensive qualities in a downturn. Technology stocks look Overall, the euro has regained the trust of many inves- expensive, but most of the companies in focus are re- tors following the elections in France and now that Eu- cording good profits and do not feature just a “business rope looks ready for a steadier growth path. This, in plan”. It is important to rebalance the portfolio in order turn, may prompt the ECB to tighten earlier, boosting to avoid concentration risk in this sector. the currency. In any case, the US dollar is under constant pressure due to the existing structural current account Bonds: a few segments left deficit.

As rates remain low and credit spreads close to historical In general, however, currency movements were rather lows, it is remarkable that most bond markets, on an small in the fourth quarter, especially when compared index level, provided positive returns. In Europe, there with the rest of the year. The Swiss franc lost another 2% are two reasons for this. Firstly, the ECB continued to against the euro. Over the whole year, the US dollar was buy government and corporate bonds, and the reduc- among the weakest currencies globally. Even the Swiss tion of political tensions coupled with some countries’ franc, while weak against the euro, gained against the hope of “debt-mutualisation” lowered rates in some of US dollar. Europe’s peripheral countries. Rates were considerably As growth rates do not differ that much between Europe lower in Portugal and Greece, while German bund rates and the US, a significant devaluation of the US dollar is were slightly higher. Long-term treasuries were very unlikely. On the other hand, the euro will only come stable in the US, but shorter-dated paper fell in price as under renewed pressure should there be higher ten- the Fed raised rates. sions within Europe. As far as political risk is concerned, In the meantime, the Fed has started to slowly reduce its the upcoming elections in Italy are in the foreground, balance sheet, and the ECB will reduce its purchases but new elections in Germany are also a not too remote from the start of this year. This will continue the trend of possibility. slightly higher rates. Within this trend, longer-dated The Swiss franc has come a long way towards purchas- bonds will follow inflationary expectations. Should there ing power parity and is no longer a drag on exports or be any surprises, higher rates and thus losses are inevi- tourism. It remains to be seen whether the Swiss Na- table for longer-dated bonds. The shorter end of the tional Bank will start to reduce their elevated foreign yield curve will be influenced by the central banks. currency holdings. This will put a cap on the further de- Corporate bonds, both investment grade and high-yield, preciation of the franc. look vulnerable within the market sectors. While high- yield bonds provide some cushion against rising credit

Schroders Wealth Management Economics and Financial Markets January 2018 6

Commodities: pick-up in demand Gold traded within a wide band, following the US dollar in the last quarter. Gold remains a “safe haven” com- During the fourth quarter and the year as a whole, modity, a role that it will not lose to cryptocurrencies commodities were in good demand, although returns anytime soon. differed between the sectors. By far the most important commodity, crude oil, gained 17% during the year (Brent), mostly in the fourth quarter. Gold gained 12% in Norbert Brestel US dollar terms while most industrial metals traded 30% Investment Communication higher compared to the beginning of the year. With the exception of wheat, Agricultural goods, however, traded lower.

Oil was pushed higher by three independent factors: Firstly, OPEC somewhat surprisingly showed a relatively high level of supply discipline; Secondly, US production did not pick up as expected following higher prices; And finally, demand started to increase due to higher growth. As long as some of these factors remain in place, further gains are possible although supply will begin to pick up at some stage.

Industrial metals profited from higher demand and sup- ply discipline. Producers still remember the supply glut and falling prices that followed overproduction in the last cycle. They will therefore increase supply, albeit only gradually.

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Schroders Wealth Management Economics and Financial Markets January 2018 7